What’s behind the new depths being tested by the rupee against a weakening dollar?

A key driver of the rupee is the market’s perception of what the Reserve Bank of India (RBI) may do. Whenever the rupee drops without a convincing explanation, the market turns to RBI for direction.

RBI has maintained that it does not target any specific level, as the exchange rate is market-determined. But in case there is too much noise, RBI starts buying or selling dollars.

The market reaction is especially predictable when there is no economic rationale for movements. Let’s suppose the rupee is at 88.75 against the dollar. The market believes that if RBI does not intervene to prevent a slide, it’s probably pleased with it, thus triggering a self-fulfilling cycle of decline. Exporters hold back on converting their dollar earnings, hoping to gain if it goes to ₹89 or ₹90. Importers, on the other hand, rush to buy dollars; else their costs would rise.

This worsens the situation, with the demand for dollars exceeding its supply and weakening the rupee even further. In 2025 so far, there has been less RBI intervention than usual, which means the exchange has been more closely market-determined.

It’s plausible that RBI sees a softer rupee as an export booster in the face of high US tariffs on India. A weaker rupee makes Indian goods cheaper abroad and thus helps our exporters compete in global markets.

Let’s get back to the question of what drives the rupee if central bank action is negligible. There are two sets of factors: ‘fundamental’ and ‘extraneous.’ The fundamentals look fairly satisfactory presently. They are best represented by India’s balance-of-payments situation.

Our trade deficit, while currently low, is likely to widen as tariffs hurt export growth, even if their impact is not very significant. The gap is sure to increase as US importers search for substitutes from countries facing lower tariffs. Capacities in competing countries like Vietnam, Sri Lanka and Bangladesh would take time to scale up, given that new machinery has to be installed and products customized for export to the US. All considered, our current account deficit this year will probably be around 1.5% of GDP, which is not worrisome.

It’s the capital account that needs some attention. Foreign portfolio investors have been whimsical this year, with withdrawals from equity markets across the world being the norm. However, given India’s growth potential, there is strong reason to invest here. Hence, the present outflows might be just a blip.

Companies have shown an increasing preference for external commercial borrowings, since such loans are cheaper, even though a weakening rupee could pose a challenge as the effective cost of servicing foreign debt goes up. Foreign direct investment has been steady but nearing a plateau. The slew of free trade agreements being negotiated with other countries will help attract more of it, and over time, our capital account should strengthen.

The ultimate test of fundamentals is our level of foreign exchange reserves. The trend on this count over the last couple of months, with the rupee under pressure, has been quite encouraging. With forex reserves around $700 billion, India’s position is very strong.

Therefore, the rupee’s ongoing decline cannot really be linked with forex fundamentals. Also, as mentioned earlier, RBI’s role has been minimal.

This leaves us with external factors, which have caused a lot of currency volatility across the world since 2022, when the Ukraine war began. This relates to the dollar’s strength, which can be gauged by either the dollar index or its equation with the euro. The dollar index has been notably weak this year (at a level of less than 100).

As for the euro, it’s now worth some $1.17-1.18. Recall that almost a year ago, the dollar had touched parity with the euro. That is long over. The dollar has weakened and is likely to weaken more as the US Federal Reserve is expected to lower its policy rate further. High US interest rates are normally associated with a stronger dollar. Low rates imply the reverse. All major currencies have strengthened against the dollar lately. But not the rupee.

The rupee is being driven by negative sentiment, given that the 50% US tariff we face is the highest among major exporters. RBI has taken a nuanced view of forex dynamics. It has relied more on the market for forward contracts; selling dollars at a later date to reduce volatility helps preserve local liquidity conditions and offers strategic flexibility. These operations have been effective at times.

Now that the rupee has crossed the 88 mark against the dollar, a fair rate may be around 88-88.50. Should it weaken beyond 89 and stay there for a week or so, a new low would be set. This has been the pattern this year. Every decline has created a new market norm for the rupee’s value in dollar terms.

These are the author’s personal views.

The author is chief economist, Bank of Baroda, and author of ‘Corporate Quirks: The Darker Side of the Sun’